Identifying and Solving Problems in the Taxation of Non-Resident Aliens. Presented to New York Step Conference. March 10, New York, New York

Transcription

1 Identifying and Solving Problems in the Taxation of Non-Resident Aliens Presented to New York Step Conference March 10, 2016 New York, New York By Leigh-Alexandra Basha, Partner/Private Client Group McDermott Will & Emery 500 North Capitol Street, N.W. Washington, D.C Shelly Meerovitch, J.D. Senior Vice President Director - Private Wealth Management 1345 Avenue of the Americas New York, NY shelly.meerovitch@bernstein.com 2016 Leigh-Alexandra Basha

2 I. Introduction In the twenty-six years since the fall of the Berlin wall, the world has seen a remarkable acceleration in the globalized movement of goods, information, and people. Today, more than ever, advisors must be prepared to provide tax and estate planning advice to clients who either are not U.S. citizens or whose spouses are not U.S. citizens. Advising such clients is complicated by the U.S. federal income and transfer tax rules, which are frequently opaque and obscure. This presentation will consist of three parts: firstly, it will provide an overview of the U.S. federal income tax and transfer tax rules as they apply to non-u.s. citizens including the effect of residency both for income and transfer tax purposes; secondly, it will address certain issues regarding pre-immigration tax planning; and finally, it will discuss certain gift and estate tax pitfalls and planning opportunities. II. Fundamentals of United States Federal International Tax Rules A. Introduction The United States is generally considered the last country in the developed world that still taxes its citizens and residents on a predominantly worldwide basis. The remainder of the developed world generally taxes only activities occurring within their respective territories. However, the U.S. international tax rules are more accurately understood as a hybrid system, where certain people and activities are taxed on a worldwide basis, but certain U.S.-based activities are taxed irrespective of citizenship or residency. These rules are especially important for non-u.s. persons who not only pay tax on certain U.S.-based activities, but also who must be wary of subjecting their worldwide foreign earnings and assets to U.S. taxation. B. U.S. Taxation on Worldwide Income 1. U.S. Citizens and U.S. Residents As a general rule, U.S. citizens and U.S. residents 1 are subject to U.S. federal income tax on their worldwide income regardless of source or character Noncitizen, Nonresidents An individual who is neither a U.S. citizen nor a U.S. tax resident is generally subject to U.S. federal income tax only on certain types of U.S.-source income which is fixed, determinable, annual, or periodic (FDAP) as well as income that is effectively connected (ECI) with the conduct of a trade or business within the United States (USTB). 3 Persons who are neither U.S. citizens nor U.S. residents (NRNCs) are generally subject to U.S. federal income tax on ECI at the regular graduated income tax rates (up to 39.6% for 2016). 4 Noncitizen, nonresidents are taxed on their U.S.-sourced FDAP income (e.g., certain interest, The author would like to acknowledge the contribution of Terry W. Stratton. 1 As this term is defined in I.R.C. 7701(b). 2 See I.R.C See I.R.C. 871, 872, 881, Nonresident aliens are, however, exempt from the 3.8% Net Investment Income tax under I.R.C. 1411(e) Leigh-Alexandra Basha

3 dividends, rents, salaries, wages, annuities, etc.) at a flat rate of 30% (or a lower treaty rate) under a gross-basis withholding regime. 5 C. U.S. Federal Transfer (Estate, Gift, and Generation-Skipping) Taxes As a general rule, U.S. federal estate, gift, and generation-skipping taxes (GST) (collectively, transfer taxes ) apply to U.S. citizens and U.S. residents on a worldwide basis regardless of the location of the transfer, or transferred assets. 6 The U.S. imposes a generation skipping transfer ("GST") tax to intervivos transfers and transfers at death to a beneficiary who is more than one generation below the transferor unless a gift or estate tax is imposed on an individual in the intervening generation. 7 The GST tax is triggered by "taxable distributions," " taxable terminations" and "direct skips." The amount of GST tax is a flat 35% of the taxable amount. 8 For application of the GST tax to a NRNC, the property must be situated in the U.S. 9 GST tax will apply to gifts and estates if they are otherwise subject to U.S. gift or estate tax. Thus, to the extent a transfer falls outside of the U.S. gift and estate tax net, then it will not be subject to the GST tax even if it otherwise would be a generation skipping transfer. The GST exemption for NRNCs is $5,450,000 in D. Worldwide U.S. Taxation - Why Status Matters 1. For Income Tax a. Individuals (i) Generally 1. U.S. citizens and residents generally are taxable on their worldwide income, subject to foreign tax credits for certain foreign taxes actually paid. 2. In contrast, the U.S. Internal Revenue Code applies two distinctive methods of taxation to the income of foreign persons. 4 First, if a foreign person carries on an active trade or business in the United States, U.S. federal income tax is imposed on all taxable income that is effectively connected with that U.S. trade or business (such income is referred to as "effectively connected income" or "ECI"). 5 For this purpose, taxable income is generally computed using the same rules as apply to U.S. persons. ECI of a nonresident is taxed at the usual marginal tax rates applicable to U.S. persons. A nonresident alien individual who is engaged in a U.S. trade or 5 See I.R.C See I.R.C. 2001(estate tax); 2501, 2503 (gift tax); 2601, 2603 (GST). 7 I.R.C I.R.C. 2602, 2641, and 2001(c). 9 Regs (b) Leigh-Alexandra Basha

4 business must file Form 1040NR with the IRS, while a foreign corporation that is at any time during the taxable year engaged in a U.S. trade or business must file a Form 1120F In contrast, income of a foreign person which is not effectively connected with a U.S. trade or business generally is exempt from federal income tax unless it is considered to be from sources within the U.S. and is of certain classes of income known as "fixed or determinable, annual or periodical" ("FDAP") income. FDAP income generally includes passive income such as interest, dividends, rents, and royalties. 7 Tax on FDAP income is required to be withheld at the source by the U.S. payor at a rate of 30 percent of the gross amount of such income, unless such rates are reduced by an applicable income tax treaty. 8 If the amounts withheld are sufficient to fully satisfy the federal income tax liability imposed for the tax year in question, the foreign taxpayer is thereby relieved of the obligation of having to file a U.S. tax return, unless the taxpayer is also engaged or deemed to be engaged in a U.S. trade or business. 9 Notably, capital gains of a nonresident are generally exempt from this FDAP withholding tax regime. 10 (ii) Real Property 1. Whether ownership of U.S. real property constitutes a U.S. trade or business is a question of fact which must be resolved on a case-by- case basis. 11 In general, to be engaged in a U.S. trade or business, a nonresident must carry on (directly or indirectly) activities in the United States that are regular, substantial and continuous. If the foreign person is engaged in a U.S. trade or business, then, as discussed above, the income from the U.S. trade or business is taxed on a net basis at the graduated rates applicable to U.S. persons generally. An election is available under which foreign persons not engaged in a U.S. trade or business with respect to ownership of U.S. real property can elect to be taxed on a net basis with respect to the rental income from such U.S. real property. 12 This allows the foreign investor to take any available deductions, for example, depreciation deductions, and to have U.S. federal income tax computed on a net basis. 6 Treas. Reg (g)(1). 7 See IRC 871(a)(1), 881(a). 8 IRC 871(a)(1), 881(a), Treas. Reg (b)(2)(i), -2(g)(2)(i). 10 Treas. Reg (b)(2)(i). 11 See Rev. Rul. 88-3, C.B IRC 871(d), 882(d) Leigh-Alexandra Basha

5 2. Gains on the sale or exchange of U.S. real property interests ("USRPI") are sourced (and thus taxable) within the United States. 13 USRPI includes real estate situated in the United States, certain associated personal property, and stock of "U.S. real property holding corporations." 14 A "U.S. real property holding corporation" is defined as a domestic corporation, at least 50 percent of the assets of which consist of interests in U.S. real property. 15 Any gain or loss of a foreign person on a disposition of USRPI is deemed to be effectively connected with a U.S. trade or business, even if the property represented a wholly passive investment of the taxpayer. Any such gain or loss is combined with other income, gain, or loss from any business actually carried on in the United States by the taxpayer. As noted above, ECI is taxed to foreign persons at the same rates as apply to U.S. persons. 3. Upon the disposition of a USRPI, U.S. law generally imposes upon the buyer an obligation to withhold and pay over to the IRS 10 percent of the gross amount realized by the seller, often equivalent to the gross purchase price. Upon the receipt by the IRS of the 15 percent withholding along with certain compliance forms, the IRS will generally provide the foreign seller with a Form 8288-A acknowledging receipt of the amount withheld and entitling the seller, upon the filing of a U.S. federal income tax return, to a corresponding credit against its actual U.S. tax liability. 16 (iii) Residency Tests An individual who is not a U.S. citizen is, unless a treaty applies, still subject to U.S. federal income tax 10 on a worldwide basis during a given tax year, if the individual: (ii) is a lawful permanent resident of the United States at any time during the calendar year (i.e., holds a U.S. green card), 11 OR (iii) satisfies the substantial presence test (explained below), 12 OR (iv) elects to be treated as a U.S. tax resident Including the 3.8% Net Investment Income tax for tax years beginning after December 31, I.R.C See I.R.C. 7701(b)(1)(A)(i). 12 See I.R.C. 7701(b)(1)(A)(ii) Leigh-Alexandra Basha

6 b. Substantial Presence Test An individual who is neither a U.S. citizen nor a green card holder will be treated as a U.S. tax resident during a particular year if he/she: (i) was physically present in the United States for at least 31 days during a particular calendar year, AND (ii) satisfies the three-year look-back rule discussed below. 14 c. Three-year Look-back Rule An individual who is neither a U.S. citizen nor a green card holder will satisfy the three-year look-back rule if the sum of (i) the number of days physically present in the United States in the current calendar year, (ii) one-third of the number of days physically present in the United States in the first preceding calendar year, and (iii) one-sixth of the number of days physically present in the United States in the second preceding calendar year equals or exceeds 183 days. 15 Under this test, a non-u.s. citizen, non-green card holder generally will not be classified as a U.S. tax resident if he/she spends less than 121 days per calendar year within the United States. d. Closer Connection Exception An individual present in the United States for less than 183 days per year who has a tax home in, and a closer connection to, a foreign country does not meet the substantial presence test. 16 e. Special Visa Classifications Some visa classifications (such as G-IV visas and student visas) get preferential treatment for U.S. income tax residency purposes. For example, G-IV visa holders working for international organizations in the United States (such as the World Bank) do not have their days counted for Substantial Presence Test purposes. 13 See I.R.C. 7701(b)(1)(A)(iii). Of note, NRA spouses of U.S. tax residents can also elect into being considered a U.S. tax resident on a joint tax return. See Spouse-Treated-as-a-Resident. 14 See I.R.C. 7701(b)(3). 15 See I.R.C. 7701(b)(3)(A)(ii). 16 See I.R.C. 7701(b)(3)(B) Leigh-Alexandra Basha

7 f. Medical Exception There is a limited medical exception to the day-counting rules. Where the taxpayer has a condition that arises in the United States that prevents him from leaving the United States, then the taxpayer can file a Form 8843 (Statement for Exempt Individuals and Individuals with a Medical Condition) and claim that those days do not count for Substantial Presence Test purposes. However, substantiation by a doctor is required, and the exception does not extend to taxpayer s spouse if travelling together. g. Day counting Because of the above tests, it is important for any noncitizen, nonresident who wishes to avoid being subject to U.S. taxation on his/her worldwide income to keep careful records of any travel to the United States on a day by day basis. 2. For Estate, Gift, and Generation Skipping Taxes In general, U.S. federal estate, gift, and generation-skipping transfer taxes apply to all U.S. citizens and U.S. residents; however, for transfer tax purposes, residency is determined based on domicile. In general, a person acquires a domicile in a place by living there, even briefly, with no definite present intention of relocating. Living in a place without intent to remain indefinitely will not suffice to establish domicile. A person s current domicile continues until a subsequent domicile is established Possibility of uncoordinated tax statuses The distinct definitions for residency between the U.S. income tax and U.S. transfer tax regimes make it possible for an individual who is not a U.S. citizen to be subject to either the federal income tax regime or federal transfer tax regime without being subject to the other. 18 Such an individual can also be subject to both regimes or neither regime. 4. Impact of Tax Treaties An individual who is a tax resident of both the United States and a country with which the United States has a tax treaty may be able to claim a treaty benefit to avoid U.S. federal taxation. Tax treaties typically contain a tie-breaker provision, which is usually a series of tests, under which one, and only one, country is deemed to be the residence country. The residence country generally, 17 See Treas. Reg (b)(1), (b). 18 For example, a noncitizen, domiciled in the United States, who works abroad for 210 days a year would be subject to U.S. transfer taxes, but not U.S. income taxation. Conversely, a noncitizen spending 150 days a year in the United States but whose permanent domicile was abroad would be subject to U.S. income taxes but not U.S. transfer taxes Leigh-Alexandra Basha

8 but with some notable exceptions, 19 has taxing priority. The non-residence country typically retains residual taxation authority. 5. U.S. Sourcing Rules The sourcing of various types of income is important for U.S. citizens, residents, and corporations because the sourcing of the income determines its eligibility for a foreign tax credit if the income is taxed by a foreign jurisdiction. A foreign tax credit is generally not available for U.S. sourced income. This may result in double taxation. For noncitizen, nonresidents, the source rules are important for determining whether income from a trade or business is effectively connected income (ECI), which is subject to graduated income tax rates, and, for certain nonbusiness income (such as FDAP), whether the 30% withholding regime on U.S. source income applies. Interest: Generally sourced based on residence of the payor. 20 Dividends: Generally sourced based on residence of the payor. 21 Personal Services: Generally sourced based on where services are performed. 22 Rents: Generally sourced based on location of rental property. 23 Royalties: Generally sourced based on location of use of intangible property. 24 Real Estate Gains: Generally sourced based on situs of the real property. 25 Capital Gains: Generally sourced based on where property was sold. 26 Inventory: Generally sourced based on place of sale, i.e., where title passes. 27 Residual Rule: Generally sourced based on residence of seller The typical exceptions include items of real property located in the non-residence country and business profits attributable to a business carried on through a permanent establishment in the non-residence country. 20 See I.R.C. 861(a)(1), 862(a)(1). But see U.S. Model, 2006, Art. 11 (under which interest is generally taxed based on the residence of the beneficial owner). 21 See I.R.C. 861(a)(2), 862(a)(2). But see U.S. Model, 2006, Art. 10 (which reduces the maximum rate on dividends imposed by the payor s resident country to 15%). 22 See I.R.C. 861(a)(3), 862(a)(3); U.S. Model, 2006, Arts , See I.R.C. 861(a)(4), 862(a)(4); U.S. Model, 2006, Art See I.R.C. 861(a)(4), 862(a)(4). But see U.S. Model, 2006, Art. 12(1) (under which royalties are taxed based on the residence of the beneficial owner). 25 See I.R.C. 861(a)(5), 862(a)(5); U.S. Model, 2006, Art. 13(1). 26 See I.R.C. 863, 865(a); 26 C.F.R ; but see U.S. Model, 2006, Art. 13(6)(under which capital gains are taxable based on the residence of the seller). 27 See I.R.C. 861(a)(6), 862(a)(6), 865(b); U.S. Model, 2006, Art. 13(3). 28 See I.R.C. 865(a); U.S. Model, 2006, Art Leigh-Alexandra Basha

9 III. Pre-immigration Tax Planning A. Introduction Because the United States taxes its citizens and residents on a worldwide basis, any person contemplating seeking such a status should consider the tax consequences that U.S. tax rules will have upon his/her foreign businesses, income, and assets and plan accordingly. B. Application of U.S. Tax Rules For U.S. federal income tax purposes, individuals generally compute their taxable income based on the cash method of accounting, which requires recognition of income upon the actual or constructive receipt of the income. 29 An individual who is planning on immigrating to the United States should therefor consider accelerating the receipt of non- U.S. source income, and triggering the capital gain on appreciated assets, which, if recognized prior to establishing U.S. residency, would generally keep such gains from being subject to U.S. income taxation. Conversely, preserving losses until U.S. residency is established enables those losses to offset later gains. However, any such preimmigration tax planning should consider both the U.S. and non-u.s. tax implications. C. Controlled Foreign Corporations As a general rule, each U.S. shareholder 30 of a controlled foreign corporation (CFC) 31 who meets certain ownership requirements must include in his/her gross income for U.S. federal income tax purposes its pro-rata share of the portions of the CFC s income, (regardless of whether or not such income is actually distributed as a dividend) which consists of: (i) Subpart F income, 32 which exceeds a certain de minimis threshold, 33 including: (a) Insurance income 34 (b) Foreign base company income 35 which in turn consists of: (1) Foreign personal holding company income, See I.R.C. 451(a). 30 See I.R.C. 951(b). 31 See I.R.C. 957(a). 32 See I.R.C. 951(a)(1)(A). 33 See I.R.C. 954(b)(3)(A). Moreover, certain items of income subject to high foreign taxes, which are greater than 90% of the U.S. maximum corporate rate, may be excluded from Subpart F income. See I.R.C. 954(b)(4). 34 See I.R.C I.R.C Leigh-Alexandra Basha

10 (2) Foreign base company sales income, 37 (3) Foreign base company services income, 38 and (4) Foreign base company oil related income 39 (5) Certain illegal payments 40 (6) Income from boycotted countries 41 (ii) Earnings invested, or considered to be invested, in U.S. property (Section 956 income). 42 D. General Pre-immigration Controlled Foreign Corporation (CFC) Planning An individual who is planning on immigrating to the United States should determine whether or not any of his/her holdings in CFCs, or foreign corporations that will qualify as CFCs following the establishment of his/her U.S. residency, generate, or will generate Subpart F or section 956 income. If it is determined that Subpart F of section 956 income might be generated, it may be advantageous to file a check the box election and convert the CFC into a flow-through entity (for U.S. tax purposes) prior to establishing U.S. residency. However, such an election may raise other U.S. compliance and reporting obligations. E. Passive Foreign Investment Company (PFIC) As a general rule, each U.S. person who receives an excess distribution 43 from a PFIC 44 must include his/her pro rata portion of the excess distribution in gross income. 45 If any portion of the excess distribution is allocable to prior tax years, interest must be paid. 46 Additionally, PFIC holdings generally must be reported on IRS Form In general, a foreign corporation is a PFIC if: (i) 75% or more of its gross income for the taxable year consists of passive income; 36 I.R.C. 954(c). 37 I.R.C. 954(d). 38 I.R.C. 954(e). 39 I.R.C. 954(g). 40 See I.R.C. 951(a)(4). 41 See I.R.C. 954.(a)(3), (5). 42 See I.R.C. 951(a)(1)(B); I.R.C See I.R.C. 1291(b). 44 See I.R.C See I.R.C. 1291(a). 46 See I.R.C. 1291(c)(3). 47 See I.R.C. 1298(f) Leigh-Alexandra Basha

11 OR (ii) 50% or more of its assets, on average, produce, or are held for the production of passive income; OR (iii) The foreign corporation previously qualified as a PFIC during the holding period. 48 Note in particular, that certain foreign insurance policies may be considered PFICs. 49 IV. U.S. Federal Transfer Taxes In general, the U.S. federal estate, gift, and generation skipping taxes (collectively, transfer taxes ) apply to U.S. citizens and U.S. residents on a worldwide basis. Noncitizen, nonresidents are generally subject to U.S. federal transfer taxes only on a much narrower basis, as explained below. 50 As explained above, for U.S. federal transfer tax purposes (as distinguished from federal income tax purposes), a U.S. resident is an individual domiciled in the United States, and a nonresident is an individual not domiciled in the United States. Generally, domicile is established by living in a place with the intent to remain. Domicile continues until a new domicile is established, supplanting the old domicile. 51 A. Domicile 1. Neither the Code nor the regulations use the term "non-resident alien" for estate and gift tax purposes. Instead, they refer to a "non-resident - not a citizen of the United States" ("NRNC"). A non-resident alien is an individual who is not domiciled in the U.S. at the time of his or her death. The regulations define a resident as an "individual who has his or her domicile in the U.S. at the time of the gift." 2. Generally, for transfer tax purposes, a foreigner becomes a U.S. domiciliary and a resident of the United States only if he or she is physically in the U.S. and also has the intention to remain indefinitely or permanently. Thus, the test of domicile in the U.S. is (1) physical presence in the U.S., even for a brief period of time; and (2) an intent to remain indefinitely. If there is no intent to remain indefinitely, there can be no domicile and the alien will be treated as a non-resident alien rather than as a resident alien. Before 1978, employees of international organizations (i.e., World Bank) who were stationed in the United States were always considered non-residents for estate and gift tax purposes. However, that is no longer the case, and since 1978, the residence status of 48 See I.R.C. 1298(b)(1) (the Once a PFIC, always a PFIC rule). 49 See IRS Notice See I.R.C. 2101(a) and 2103 (estate tax); I.R.C. 2501(a) and 2511(a) (gift tax). 51 See Treas. Reg (b)(1) Leigh-Alexandra Basha

12 such a person depends on his or her intent, just as it does in the case of a foreign business person. 3. Set forth below is a list of the major factors which should be considered in determining domicile: a. The duration of stay in the United States and in other countries, and the frequency of travel both between the U.S. and other countries and between places abroad; b. The size, cost and nature of the decedent's houses or other dwelling places, and whether those places were owned or rented; c. The area in which the houses and other dwelling places are located; d. The location of expensive and cherished personal possessions; e. The location of the decedent's family and close friends; f. The place where he/she maintained church and club memberships; g. The location of his/her business interests; h. Declarations of residence or intent made in visa applications for reentry permits, wills, deeds of gift, trust instruments, letters and oral statements; and i. Motivation, especially health, pleasure, business and avoidance of the miseries of war or political repression Leigh-Alexandra Basha

13 B. U.S. Gift Tax Considerations 1. U.S. gift tax applies to U.S. citizens and U.S. domiciliaries (those resident in the U.S. for transfer tax purposes) on a worldwide basis and no matter where the transferred asset is situated to the extent that the value of the property transferred exceeds the amount of the exclusions and deductions allowable. 52 However, for NRNCs., U.S. gift tax only applies to the transfer of U.S. situs tangible personal property and U.S. real property. 2. Further, it is possible that the U.S. could determine an alien to be domiciled in the U.S. and one or possibly several other countries might hold the same person to be domiciled in that country or countries. However, one should review applicable estate and gift tax treaties which serve the purpose of preventing the double taxation of individuals. 3. Under U.S. federal gift tax law, U.S. citizens and U.S. residents (domiciliaries) who transfer property by gift are subject to a U.S. gift tax on completed gifts of real or personal property (whether tangible or intangible) on the same unified rate schedule that applies to federal estate taxes. 53 The tax is generally paid by the donor. 54 There is an annual exclusion which permits annual gifts up to $14, (or $28,000 if married and gift-splitting 56 ) per donee (with no limit on the number of donees) to be excluded from the taxable gift amount. 57 Additionally, inter vivos gifts which exceed the annual gift exemption can be applied against the unified gift and estate tax credit 58 of $5,450, Gifts to a U.S. citizen spouse are fully deductible from the taxable gift amount U.S. gift tax applies to a gift of all interests in U.S. real property if the value exceeds $14,000 in 2016 per donee. NRNC grantors are subject to tax on their accumulated gifts over their lifetime at a maximum rate of 40% in They are not eligible for any lifetime applicable exclusion amount for gifts in excess of the annual exclusion gift. Other transfer taxes may also apply, such as the generation skipping transfer tax If the donee is a U.S. citizen spouse of the donor, the transfer will be eligible for the gift tax marital deduction and will be non-taxable provided 52 I.R.C. 2501(a)(1). 53 See I.R.C. 2001(c), 2501, 2502(a). 54 See I.R.C. 2502(c). 55 As of See I.R.C. 2503(b); Rev. Proc , Sec Indexed for inflation. 56 See I.R.C Note that gift-splitting is only available if, at the time of the gift, each spouse is either a citizen or a resident of the United States. 57 See I.R.C. 2503(b). 58 See I.R.C As of See I.R.C. 2010; Rev. Proc , Sec Indexed for inflation. 60 See I.R.C. 2523(a). 61 This is a flat 45% (as of 2008) tax over the exemption amount [ 2602] Leigh-Alexandra Basha

14 it meets the marital deduction requirements. 62 If the donee spouse is a non-u.s. citizen, then the donor is eligible for an increased annual exclusion for such gifts of $148,000 per year in Exemptions from gift tax by a non-resident alien donor include gifts of stock in a domestic or foreign corporation and a domestic or foreign partnership. Thus, if U.S. real property is gifted, the donor is subject to U.S. gift tax at fairly onerous rates. However, if the U.S. real property is owned through a corporation (U.S. or foreign) and the corporate stock (U.S. or foreign) is gifted by the NRNC, the transfer is exempt from U.S. gift tax. 7. A treaty may override the gift and generation skipping transfer tax provisions. FIRPTA withholding does not apply to gift transfers. Gifts of partnership interests as non U.S. situs intangible property should also be exempt from gift tax by a NRNC, however the U.S. tax treatment of gifts of a partnership interest is not clear. There are cases and other authority finding in some instances, the gift of a partnership interest is an intangible and others finding that if the partnership holds U.S. real estate, it is a gift of the underlying asset. 63 Further, under anti-abuse theories, if the partnership is created for the sole purposes of circumventing the gift tax, then the Service may be successful in arguing it is a gift of a U.S. situs asset Under U.S. federal gift tax law, noncitizen, nonresidents (nondomiciliaries) are generally subject to gift tax only on completed gifts of real property or tangible personal property situated or deemed situated in the United States. 65 The situs of real and tangible personal property is based on the physical location of the property. NRNCs are not subject to federal gift tax on transfers of intangible property. 66 As such, when a NRNC makes a completed gift of corporate stock (whether domestic or foreign) the transfer is generally not subject to U.S. federal gift tax. 67 There is no marital deduction available for gifts made to a spouse who is not a U.S. citizen. 68 However, every donor spouse (U.S. or foreign) is entitled to gift up to $148,000 to a non-u.s. citizen spouse free of gift 62 I.R.C Bodgett v. Silberman, 277 U.S. 1 (1028) held that the interest in a partnership owned by the decedent was an intangible for state inheritance tax purposes. PLR and Rev Rul , CB 465 found a partnership interest to be an intangible not subject to gift tax. GCM 18718, CB 476, declared obsolete CB 280 concluded that the interest in a partnership is itself personal property. 64 Reg See I.R.C. 2501, 2511 and Treas. Reg , See I.R.C. 2501(a)(2). 67 See I.R.C. 2501(a)(2), 2511(a). Note however that if the noncitizen nonresident makes a completed gift of an interest in a foreign entity that is treated as a partnership for U.S. tax purposes, the analysis is complicated by the risk that the foreign entity may be disregarded and the transaction viewed as though the noncitizen nonresident made a transfer of a proportionate share of the underlying assets. 68 See I.R.C. 2523(i) Leigh-Alexandra Basha

15 tax. 69 But in order to qualify any such gifts must be of a present interest in the gifted property, 70 and any gift of a future interest, must be reported on IRS Form 709. Gifts to a noncitizen, nonresident spouse that exceed the annual exemption cannot be counted against the estate tax exclusion. Finally, QDOTs are limited to transfers upon death and are not available for lifetime gifts to a NRNC spouse. 9. An individual who is planning on immigrating to the United States should consider completing any contemplated gifts prior to establishing residency in the United States. In particular, any gifts between non-u.s. citizen spouses should be completed prior to immigration because of the rather limited available spousal exemption amount. 71 C. Estate Tax Rules and Considerations 1. Taxable Estate A. If the decedent is a citizen or resident (domiciliary) of the United States at death, the federal estate tax generally applies to all property transferred at death, regardless of geographic situs. 72 For NRNC decedents, the U.S. federal estate tax usually applies only with respect to U.S. situs assets. 73 The gross estate of a NRNC includes the decedent s U.S. real property and tangible and intangible property situated in the U.S. at the time of death. B. Several exceptions exist, (e.g., certain life insurance proceeds, bank deposits and certain debt obligations). However, a non-u.s. domicilary s stock in a domestic corporation (but not a foreign corporation) is includible in the non-u.s. domiciliary's U.S. estate. Thus, if such a NRNC owns real property directly or through a U.S. corporation, the interest will be includible in his or her U.S. taxable estate, but not if the U.S. real property is owned through a foreign corporation. C. The situs of a partnership interest owning U.S. real property is uncertain because neither the Internal Revenue Code nor the Treasury Regulations define a partnership interest (neither foreign nor domestic) as U.S. situs or non U.S. situs for estate tax purposes. The Service may determine a partnership interest under one of two theories: the entity theory or the aggregate theory As of See I.R.C. 2010; Rev. Proc , Sec. 3.35(2). Indexed for inflation. 70 See I.R.C. 2503(b). 71 See Appendices B & C for an additional breakdown of tax treatments of U.S. and non-u.s. situs assets. 72 I.R.C. 2001(a). 73 See I.R.C. 2101(a). 74 Rhoades and Langer, U.S. International Taxation and Tax Treaties v. 2; Cassell, Karlin, McCaffrey, and Streng, U.S. Estate Planning for Nonresident Aliens Who Own Partnership Interest, 99 Tax Notes 1683 (Tax Analysts June 16, 2003), reprinted in 31 Tax Notes Intl 563 (Tax Analysts Aug 11, 2003) Leigh-Alexandra Basha

16 Under the entity theory, the partnership interest is an intangible and not subject to gift tax. Under the aggregate theory, the one looks to the underlying assets in the partnership to determine if any of them, if given separately, would generate a gift tax. Old case law points to the partnership interest as being an intangible for purposes of the estate tax. 75 The Service determines the situs of the partnership interest according to where the partnership conducts its business rather than the situs of the assets it holds. Thus, the safest view from a planning perspective is to treat a partnership interest which is engaged in a U.S. trade or business as U.S. situated. D. The U.S. estate tax arguably does not apply to a partnership that is not engaged in a U.S. trade or business. Therefore, if the U.S. real property interest is unrented residential real estate or raw land held for investment, a partnership interest (or LLC interest taxed as a partnership) may not be considered U.S. situs and not includable in the decedent s U.S. estate. Nonetheless, the disposition of such interest would still be considered effectively connected to a U.S. trade or business. E. Once the non-resident alien s U.S. estate tax is determined, it is granted a $60,000 exemption equivalent (i.e., a credit of $13,000). 76 Amounts in excess of this are taxed at graduated rates up to 40% (in 2016). A treaty may provide some relief. F. Given the estate tax ramifications of a non-resident alien s holding U.S. real property either directly or through a partnership or domestic corporation, many non-resident aliens prefer to hold U.S. real property interests through a foreign corporation or to purchase a life insurance policy sufficient to cover the estimated estate tax liability. The problem with owning U.S. real property interests through a foreign corporation is the branch profits tax, although several treaties substantially reduce this. If no such treaty applies, then a tandem structure of a U.S. subsidiary owned by a foreign parent may be preferred. This structure permits the avoidance of U.S. estate tax and the avoidance of the branch profits tax. Alternatively, structuring foreign investment in U.S. real property through debt can be attractive because, if structured properly, both the interest and the note can be exempt from income and estate tax under the portfolio interest exception. 75 Boldgett v Silberman, 277 U.S. 1 (1028). 76 I.R.C. 2102(b) Leigh-Alexandra Basha

17 2. Marital Deduction A. Transfers made to a U.S. citizen spouse are typically fully deductible from the taxable estate. 77 Transfers made to a noncitizen spouse however, are not deductible 78 unless properly made at death through a Qualified Domestic Trust (QDOT) 79 in a timely manner or a tax treaty with a marital deduction allowance provision applies. 80 A QDOT basically ensures the U.S. will collect estate tax at the death of the non U.S. citizen surviving spouse or upon principal distributions during the life of the surviving spouse. B. Generally, these rules apply regardless of the citizenship or residence of the transferor and also regardless of the tax residence of the surviving spouse (for example, while a green card holding surviving spouse is subject to U.S. income taxes, he/she generally 81 cannot benefit from the unlimited marital deduction available to U.S. citizen spouses). 82 Of note, some treaties do provide for a limited marital/spousal deduction (i.e., the U.S.- France Estate and Gift Tax Treaty). Thus, you should always consider the impact of any treaty on the availability of a marital deduction. 3. Unified Applicable Exclusion U.S. citizens and residents (domiciliaries) are entitled to the benefit of the basic unified estate and gift exclusion of $5,450, Noncitizen, nonresidents are entitled to an estate exclusion of only $60, This exclusion amount is not available for lifetime gifts. 4. Federal Estate Tax Rates Above the applicable exclusion, graduated U.S. federal estate tax rates (up to 40%) apply See I.R.C See I.R.C. 2056(d). 79 A QDOT is a essentially a security device for ensuring that, either upon the distribution of principal from the trust during the spouses lifetime, or at the spouse s death, the trust principal will be subject to U.S. federal estate tax as if it had been included in the estate of the transferor spouse. A QDOT can be established by either the transferor spouse, transferee spouse, or by the executor of the transferor spouse. 80 See I.R.C. 2056(d)(2). 81 If a noncitizen surviving spouse becomes a U.S. citizen before the estate tax return must be filed, and was U.S. resident at all times between the decedent s death and becoming a U.S. citizen, the marital deduction is allowed. See I.R.C. 2056(d)(4). 82 See I.R.C As of See I.R.C. 2010; Rev. Proc , Sec Indexed for inflation. 84 See I.R.C. 2102(b). 85 See I.R.C. 2001(c) Leigh-Alexandra Basha

18 V. Exit Tax Rules 5. Incomplete Gifts The gross estate includes the value of all property interests held by the decedent at death. 86 However, if the decedent transferred property while retaining a life estate, the full value of the property, as of the date of death, 87 is included in the gross estate Three-Year Gift Look-Back Rule As a general rule, the gross estate also includes gifts made within the 3- year period ending on the date of death and any gift tax paid thereon General Pre-Immigration Estate Tax Planning An individual who is planning on immigrating to the United States should consider transferring assets out of his/her taxable estate prior to establishing residency in the United States. It is also advisable to consider the estate tax consequences of acquiring U.S. situs assets without, or prior to, establishing a U.S. domicile. However, any such transfers should consider both the U.S. and foreign tax implications. A. Introduction Because the United States taxes predominantly based on citizenship or residency status, ceasing to be a U.S. citizen or permanent resident affects one s U.S. tax burden. In order to mitigate tax incentives for expatriation, the U.S. imposes an exit tax. Thus, the consequences of losing, abandoning, or surrendering a green card, or passport and ceasing to be a citizen or permanent resident, include not only the loss of entry, reentry, and residency privileges, but may also trigger an exit tax on the worldwide assets of the expatriate. B. What is the exit tax? Under the Heroes Earning Assistance and Relief Tax Act of 2008 (HEART), which went into effect on June 17, 2008, 90 certain high net worth individuals who relinquish their U.S. citizenship or long-term resident status are Covered Expatriates and subject to an exit tax on the deemed sale of their worldwide assets. 86 I.R.C Or as of the Alternative Valuation Date, which is six months after the decedent s death. I.R.C I.R.C See I.R.C , Those expatriating prior to June 17, 2008 are subject to a prior, different expatriation regime Leigh-Alexandra Basha

19 C. Who is subject to the exit tax? 1. An expatriate is either: a. any U.S. citizen who relinquishes his/her citizenship; 91 OR b. any long-term resident (defined as any noncitizen who has been a lawful permanent resident for eight of the fifteen taxable years prior to expatriation) 92 of the United States, who ceases to be a lawful permanent resident of the United States The expatriation date is: a. the date an individual relinquishes 94 his/her U.S. citizenship; 95 OR b. the date a long-term resident of the United States ceases to be a lawful permanent resident. 96 A long-term resident ceases to be a lawful permanent resident when such status has been revoked, or administratively or judicially determined to have been abandoned A Covered Expatriate is any expatriate who: a. had an average income tax liability in excess of $161, for the five tax years prior to the expatriation date; 99 OR b. had net worth of $2,000,000 or more as of the expatriation date; 100 OR 91 I.R.C. 877A(g)(2)(A). 92 I.R.C. 877A(g)(5), 877(e)(2). 93 I.R.C. 877A(g)(2)(B); I.R.C. 7701(b)(6). 94 Relinquishment of citizenship for U.S. tax purposes requires certain formalities that may or may not overlap with relinquishment of citizenship for U.S. Immigration purposes. See I.R.C. 877A(g)(4). 95 I.R.C. 877A(g)(3)(A). 96 I.R.C. 877A(g)(3)(A). 97 I.R.C. 7701(b)(6). 98 As of See I.R.C. 877(a)(2); Rev. Proc , Sec Indexed for inflation. 99 I.R.C. 877(a)(2)(A). 100 I.R.C. 877(a)(2)(B) Leigh-Alexandra Basha

20 c. fails to certify under penalty of perjury that he/she has complied with U.S. tax requirements for the five years preceding the expatriation date. 101 D. How is the tax calculated? 1. Mark-to-market taxation The Covered Expatriate is deemed to have sold all of his/her property, no matter where it is situated, for its fair market value on the day before his/her expatriation date and required to pay U.S. income tax on the portion of the gain that exceeds $693, Generally, all assets, whether located in the United States or elsewhere, are subject to the worldwide exit tax. This includes certain deferred compensation items and retirement accounts. The Covered Expatriate is deemed to have received the present value of his/her accrued benefit on the day prior to expatriation 103 regardless of whether the Covered Expatriate does or does not currently have access to such benefits. Be aware that if an individual has ever been a U.S. resident in the past (held a green card) that could impact whether or not he owes an exit tax; and that could potentially lead to an inheritance tax for assets gifted or bequeathed from Covered Expatriates to U.S. Persons 104. E. Perpetual Succession Tax on Gifts & Bequests from Covered Expatriates Section 2801 imposes a succession tax, payable by the recipient, on gifts or bequests from a Covered Expatriate to a U.S. individual or U.S. trust. 105 To the extent that a gift or bequest from a Covered Expatriate to a U.S. recipient exceeds the $14,000 annual gift exclusion, 106 (or another tax benefit, such as the marital or charitable deduction) the recipient is subject to U.S. taxation at the highest marginal estate or gift tax rate, 107 currently 40%. 108 There is no sunset provision, meaning the tax applies in perpetuity until after the Covered Expatriate has died and his/her estate has been closed. The Treasury recently issued proposed regulations that define the relevant terminology and also delineate exceptions to the taxation of covered gifts and bequests. 109 Some of the highlights of these 101 I.R.C. 877(a)(2)(C). 102 As of I.R.C. 877A(a). See Rev. Proc , Sec Indexed for inflation. 103 I.R.C. 877A(d)(2). 104 I.R.C I.R.C As of See I.R.C. 2503(b); Rev. Proc , Sec Indexed for inflation. 107 I.R.C. 2001(c). 108 I.R.C Treas. Reg , -2, -3. The exceptions include taxable transfers paid and included on the covered expatriate s timely filed estate or gift tax return, qualified disclaimers, charitable donations that qualify for a charitable deduction, spousal transfers that qualify for the marital deduction, and transfers to QDOTs. Id Leigh-Alexandra Basha

21 proposed regulations include the definition of the U.S. person recipient. For non U.S. citizens, a U.S. person is defined as a U.S. domiciliary based on the transfer tax criteria. The proposed regulations also address how a recipient is to gain confidential information from a Covered Expatriate and how distributions from trusts are to be treated. They also address transfers via powers of appointment, beneficiary designation etc. The IRS will be issuing a new Form 708 to report the 2801 tax. VI. Tips, Tricks, and Traps in Estate Tax Planning A. Introduction While each client s circumstances are unique, situations involving cross-border assets, cross-border residency, and cross-border marriages commonly create the necessity and/or opportunity for income tax and estate tax planning. B. The 2015 EU Choice of Nationality Election The EU Parliament and the EU Council approved rules in June 2012 that permit a testator to choose the law of his or her country of nationality (defined as a testator s citizenship). The main features of the proposal allow for a single law to govern a succession document, mutual recognition of decisions in the European Union, and the status of heir, administrator, and executor is recognized on the basis of the European Certificate of Succession. These rules came into force on August 17, Denmark, the UK, and Ireland have opted out of these rules. Also of note, some other non-eu jurisdictions permit a testator to choose the law of his or her nationality to govern the devolution of the testator s estate (e.g., Switzerland). C. Forced Heirship Issues and 2015 Election Effect in the E.U. - Application to the Example The effect of the E.U. Election, which went into effect August 17, 2015, is profoundly important to U.S. citizens who hold assets in E.U. countries like France, Italy and Germany with forced heirship regimes. By making the election in their wills and choosing to have the law of their country of nationality govern the disposition of their assets, U.S. citizens with assets abroad can avoid the potential default rules of forced heirship in civil law jurisdictions. This is beneficial to those U.S. citizens who have substantial assets in the E.U. as it allows for them to leave those assets to those they intended rather than having the civil code dictate to whom and in what amount those assets are to pass. D. International Marriages 1. Non-U.S. Citizen, Non U.S. Resident to a U.S. Citizen Spouse A non-u.s. citizen, non U.S.-resident spouse can use the unlimited spousal deduction to avoid the U.S. federal estate tax to the extent that he/she Leigh-Alexandra Basha

22 bequeaths assets to a U.S. citizen spouse. 110 However, beyond the unlimited marital deduction for bequests to a U.S. citizen spouse, a non-u.s. citizen, nonresident (nondomiciliary) is limited to a $60,000 exemption 111 and the remainder of the estate is subject to federal estate tax at graduated rates up to 40% U.S. Citizen or U.S. Resident to a Non-U.S. Citizen Spouse There is no marital deduction if a U.S. citizen or U.S. resident predeceases his/her non-u.s. citizen spouse. 113 Although there is no unlimited marital deduction in the case of a non-u.s. citizen spouse, there is an elevated annual exclusion amount for annual inter vivos transfers to a noncitizen spouse ($148,000 for tax year 2016). 114 This amount passes gift-tax free and allows the donor to avoid using any of his or her lifetime exemption amount from gift tax. 115 If assets are not gifted during the U.S. citizen or U.S. resident spouse s lifetime, assets passing to a surviving non-u.s. citizen spouse in excess of the decedent s applicable exclusion amount ($5,450,000 for tax year 2016) 116 are only deductible if (1) the non-u.s. citizen spouse both was a U.S. domiciliary and became a naturalized U.S. citizen before Form 706 Federal Estate Tax Return is due to be filed, 117 or (2) the assets are transferred to a Qualified Domestic Trust (QDOT). 118 QDOTs are an estate planning vehicle which, if properly set up and maintained, can defer the estate tax liability. If the trust satisfies the requirements of a QDOT, then distributions from principal before the death of the surviving noncitizen spouse will be subject to tax as if the distributions had been includable in the deceased spouse s estate (i.e., one applies the decedent s estate tax rate). Any assets remaining in the QDOT at the surviving spouse s death will also be subject to estate tax, again at the estate tax rates of the predeceased spouse and subject to portability. Distributions from principal during the surviving spouse s life and at the surviving spouse s death are both estate taxable events The Six Basic QDOT Requirements: (i) Ordinary Trust Requirement - The QDOT must be eligible to be classified as a trust under the Code, meaning that it must be an arrangement whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in 110 I.R.C. 2056(a). 111 See I.R.C. 2102(b). 112 I.R.C. 2001(c). 113 I.R.C. 2056(d). 114 I.R.C. 2523(i)(2). 115 I.R.C. 2523(i)(2); Rev. Proc See I.R.C. 2010; Rev. Proc , Sec Indexed for inflation. 117 I.R.C. 2056(d)(4); Treas. Reg A. 118 See I.R.C. 2056(d)(2). 119 See I.R.C. 2056(d)(2), 2056A; Treas. Reg A Leigh-Alexandra Basha